Friday, February 04, 2011

Don’t be fooled by illusory numbers

So often investors and entrepreneurs look at the wrong financial numbers and ratios when analysing companies. They focus obsessively on the latest year’s pre-tax profits, or perhaps post-tax earnings. But these can often be manipulated, or temporary. What matters much more are underlying sales, strong gross margins and free cash flow. Study these numbers over several years to see if a business really owns a solid franchise.

When an enterprise enjoys consistently solid sales as a percentage of capital employed, and high gross margins, then it should by rights make a decent bottom line and an attractive return on investment. And by high gross margins, I mean 60 per cent or more. Companies that enjoy this scale of margins – and keep their fixed costs within reasonable boundaries – should prosper.

Of course, companies with huge mark-ups over their raw costs are more vulnerable to being undercut by discounters. But it is always better to start with a lot of margin than a low gross margin. When I was involved with PizzaExpress and Strada, I learnt that the pizza business offers spectacular margins, better than anything else in the restaurant trade. Given the way menu prices have risen relentlessly, the major chains must enjoy gross margins of at least 80 per cent on their pizza, or a mark-up of 400 per cent over cost. Yet surprisingly, no one has come in to undercut them and offer a comparable product at half the price.

One of the more astonishing retail phenomena in Britain in recent years has been the sudden explosion of specialist shirt retailers. A large operator explained to me why: shirts wear out rather faster than say, suits; and shirts can achieve an 80 per cent gross margin – even if they are sold at only £30 or so.

By the same token, part of the reason electronics retailers are disappearing is that their gross margins are 20 per cent or even less. Even with big ticket unit prices, rents, property taxes, wages and other costs are killing the model. Similarly, most greetings card retailers have survived, despite the steady decline in their market, because their gross margins can be as high as 90 per cent. And part of the reason software companies have grown so rich, and software start-ups receive so much venture capital is their almost 100 per cent gross margins, if research and development are discounted.

Decades ago, shares were valued on a multiple of post-tax earnings – a P/E ratio. More recently, acquirers have adopted the private equity model using the ratio of enterprise value to earnings before interest depreciation and amortisation (EV/ebitda). This suited the inflationary environment for asset prices. Even now the two yardsticks are often conflated – sometimes accidentally, sometimes not.

But the fundamental problem with using ebitda as a gauge of profitability is that deprecation is typically a real cost. A business might be able to take a brief holiday, but eventually there will be a lot of catch-up spending to do. A plant has to be replaced, equipment upgraded, worn out buildings renewed. A better method is to judge sustainable post-tax profits after maintenance, capital expenditure and working capital adjustments. This net figure might be called free cash flow. They are the liquid funds available for interest, dividends or acquisitions.

A surprising proportion of companies never really shows a genuine free cash return – they are essentially a charity for their staff and customers. I used to feel that about the nightclub business: even though you could make juicy profits for a few years, there needed to be a complete reinvention every three years or so – new lighting, sound and so on – just to compete with newcomers. That investment typically represented three years’ profits. Effectively the whole undertaking just stood still. I fear the industry has become even tougher in recent times.

So my advice is to search out industries where you can capture at least a 60 per cent gross margin. And when examining a company’s accounts, focus on actual cash flow after cash costs, rather than illusory numbers such as earnings or ebitda.